Short Selling Disclosure Rules

Fund managers are gearing up for a fight regarding short selling disclosure rules (see Financial Times article). The FT article discusses how the fund industry would be damaged by such timely and public disclosures, basically arguing that no one would pay for investment advice or money management when the relevant information can be had for free a day or so later. Yet, this argument may miss the most interesting point - that a ban or disclosure rule is certain to have some unintended consequences.

Bans on short selling have had a goal of trying to limit funds from manipulating the market, but making short selling positions public could just exacerbate the problem. Non-public disclosure would allow regulators to monitor positions and funds, insuring that market manipulation was not occurring, yet by making the short data public, others would now be tempted to jump on the momentum train, increasing their short positions, and the selling pressure on the shorted security. In the end, this may do nothing to decrease market manipulation, while still allowing the funds to profit from the falling prices.

If increased selling is the potential fall-out of public disclosure, then why should funds care? I suspect there are two reasons. First, if they are taking a large (but allowed) short position, it may take more than a day to enter or exit the position. One day of disclosure could potentially reduce the profitability to the fund as others front-run the trade. Second, and maybe more critical, is that any short momentum trades that result in a large sell-off or company failure will still ultimately get blamed on the funds, causing regulators to once again implement short-selling bans. For the funds that have strategies that rely on being able to take a short position, such a ban affects viability as much as it does profitability.

Currently, longer disclosure periods are being discussed, such as two weeks or even a month. While this may help with the first problem of having enough time to enter and exit a position, it will do less for the second unless the disclosure period is long enough to limit profit opportunities for those who later try to mimic the trade. Too short a disclosure period, and you encourage copy-cat trades and additional selling pressure. Too long, and the disclosure simply becomes a record of what companies were short. Anything in between provides the potential for market manipulation with little benefit to market efficiency over what non-public disclosure would most likely offer.